Global gas consumption still trails behind oil and coal. Yet, demand for natural gas has grown substantially over the last three decades, outpacing the growth of demand for oil. The International Energy Agency (IEA) projects gas consumption to grow 42 percent by 2030.
There are currently two mechanisms for pricing natural gas: oil indexation, which links gas prices to oil, and a spot market or hub-based model, in which the price of gas is determined by market competition. Oil indexing emerged in Europe in the 1960s, and spread to Asia, where it remains the prevalent model. Spot market pricing developed in the United States and began to spread in Europe in the 1990s, after the liberalization of the UK natural gas market. In the past couple of years, Europe’s gas market emerged as the battleground of an increasingly intense competition between these two pricing mechanisms.
To launch his new report Natural Gas Pricing and Its Future: Europe as the Battleground, Anthony Melling discussed the background and potential outcomes of the competition between the two natural gas pricing mechanisms. Carnegie hosted Melling, along with Deloitte’s Branko Terzic, Vello Kuuskraa of Advanced Resources International, Hidehiro Nakagami of Tokyo Gas, Mikhail Korchemkin of East European Gas Analysis, Chris Goncalves of Charles River Associates, and Carnegie’s Adnan Vatansever, to discuss the report and its wider implications.
The price of gas purchased under European long-term contracts is tied to the price of oil. In 2009, several conditions converged to create an over-supply of natural gas. Large quantities of gas sold under short-term contracts at commodity prices became available, in some cases selling for half the price of oil-indexed gas. As a result, incumbent wholesalers—who had long-term contracts with producers that forced them to pay high oil-indexed prices— found themselves unable to charge their customers an amount close to what they paid for the gas. Unable to sell the large amounts of gas they had contracted for, they ended up owing billions of dollars in penalties to the producers.
The crisis had an impact not just in Europe, but in other parts of the world as well. It affected gas sales revenues, which are essential to the governments of Russia and Algeria, both of which are proponents of oil-indexing. The crisis was also felt in Asia, where the oil-index model remains dominant.
Currently, many producers are still selling gas at oil-indexed prices while others are selling at market value. While there is little doubt that more producers will eventually move to using spot market prices, oil-indexed producers are not giving up without a fight. The issue of which pricing model to use will have wide-ranging implications:.
Melling outlined the possible ways in which the ongoing competition between oil-indexation and market-based pricing might be resolved.
In the United States, 17 percent of the energy consumption for electric power generation currently comes from natural gas, as opposed to 51 percent from coal, 21 percent from nuclear power, 9 percent from renewable energy sources, and 1 percent from petroleum.
Natural gas carries multiple advantages for electricity generation, both in the United States and in Europe: it is available, deliverable, and significantly cleaner than coal in terms of carbon dioxide emissions.
If gas is to play an increasing role in power generation, natural gas contracts must respond to the needs of competitive electricity generators, Terzic stated. He argued that for power generators in Europe, spot gas supply agreements (GSAs) are preferable to long-term, oil-indexed ones.
In the United States, the availability of shale gas has changed the outlook for natural gas, effectively mitigating fears of impending natural gas shortages. Unconventional gas, such as shale gas, accounts for more than 60 percent of all U.S. gas production.
In order to realize the potential impact of shale gas on European markets, producers must first resolve several important questions, Kuuskraa said.
Gazprom, which sells gas to Europe in long-term take-or-pay contracts based on oil-indexed prices, has seen a steady loss of market share in Europe over the last decade.
The natural gas market in Japan and Asia in general is highly constrained, compared to the more liquid markets in the United States and Europe, Nakagami said.
The Carnegie Russia and Eurasia Program has, since the end of the Cold War, led the field of Eurasian security, including strategic nuclear weapons and nonproliferation, development, economic and social issues, governance, and the rule of law.
The Carnegie Energy and Climate Program engages global experts working on issues relating to energy technology, environmental science, and political economy to develop practical solutions for policymakers around the world. The program aims to provide the leadership and the policy framework necessary to minimize the risks that stem from global climate change and to reduce competition for scarce resources.
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